Using Gap Zones to Create a Profitable Strategy for the Opening Gap Scott Andrews

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Overview The Basics, Promise & Dilemma Solution: Gap Zones The Math Two Weeks in the Life of a “Gapper” Summary Q & A

Definitions Gap – difference between the prior day close and next day’s opening price (regular session / pit hours). Fade – to trade in the opposite direction of the gap. Gap Fill – when price retraces from the opening back to the prior day’s close. Win Rate – percent of gaps that, if faded at the open, filled the gap or could have been exited at the end of the day for a profit. Profit Factor – the ratio: (profits from winners) / (losses from losers) measures the historical profitability of a given setup. This is more important than “win rate.” “Gapper” - a unique individual that has evolved beyond his/her trading peers by recognizing the superior return on time, effort and capital of the "gap fade." This elite trader can be recognized by his/her enviable lifestyle & finances.

Why I Love Gaps Gaps have an inherent bias and edge (>70% win rate). They occur frequently (three to four tradable gaps per week in the S&P). It's an easy trade to learn and play. I can prepare in about 15 minutes before open. I can trade them without charts and from anywhere. Getting filled with minimal slippage is not an issue. The entry and target are pre-defined so I don't have to manage the trade. My risks are limited and controlled - no overnight risk. They work in bull and bear markets equally well – no need to predict the market’s next move. They occur in most asset classes and can be traded using stock, options, and futures contracts. I can grow my account significantly with this single, simple setup & one market. Understanding the bias of the market before and after the gap fills, provides a trading edge for the rest of the day while also helping optimize my entries on swing and position trades.

The Promise of Gap Fading Year Number of Gaps Win % 2008* 79* 72.2% 2007 225 64.9% 2006 200 72.5% 2005 196 71.4% 2004 213 72.3% 2003 211 75.4% 2002 229 73.4% 2001 208 74.0% 2000 223 73.5% 1999 236 75.9% 1998 226 73.0% Total: 2,246 72.4% The vast majority of opening gaps will retrace back to the prior close at some point during the day * January 1 - April 30, 2008 “Win %” is based upon hypothetically fading opening gaps > 1 point in the E-Mini S&P 500 futures, 1998-2007, using no stop, targeting prior close, exiting end of day if gap did not fill. This not a recommended strategy.

The Paradox Year Profit Factor 2008* 1.24 2007 0.71 2006 1.01 2005 1.05 2004 1.11 2003 1.30 2002 1.14 2001 1.16 2000 0.94 1999 1998 1.06 Average: 1.08 (yawn) High win rate does not equate to big profits. January 1 - April 30, 2008 Profit factor = total profits of winners / total losses from losers Though an extremely high win rate, the profits from the winners barely exceed the losses from the losers.

The Dilemma Using small stops does not improve Stop As % of Gap Size % Win Average Win/Loss Ratio Profit Factor 25% 21.4 3.49 0.95 50% 36.0 1.80 1.01 75% 47.0 1.18 1.05 100% 53.7 0.91 1.06 125% 59.0 0.73 150% 61.8 0.64 1.04 175% 64.7 0.57 200% 66.1 0.53 1.03 Note: 1998 – 2007, E-Mini S&P 500 futures. Using small stops does not improve profitability due to the reduction in win rate.

The key to making money fading opening gaps is… SELECTION

Gap size is not correlated with profitability. Filter by “Size of Gap”? Fading 1- 3 point gaps at the open, using a 6 point stop: 78.0 % filled or finished profitable (687/881) Profit factor:  1.17 Fading gaps > 10 pts at the open, using a 6 point stop:  37.5% filled or finished the day profitable (91/243) Profit factor = 1.17 Note: based on E-mini S&P 500 futures, 1998 - 2007 Gap size is not correlated with profitability.

A Solution…

“Location, location, location”… applies to gaps too! “Gap Zones” High Close Open Low Definition: location of the gap relative to the prior day’s key price levels: Open, High, Low and Close. “Location, location, location”… applies to gaps too!

Why Gap Zones Work They inherently incorporate: Support and resistance High Close Open Low They inherently incorporate: Support and resistance Short term trend Gap size Trader psychology

Gap Zone Areas Prior Day Potential Next Day Gap Areas Above the high Below the high & above the open or close Between the open and close Below the open or close & above the low Below the low

Gap Fade Win % All gaps > 1 point = 72.4 % “Win %” is based upon hypothetically fading opening gaps > 1 point in the E-Mini S&P 500 futures, 1998-2007, using no stop, targeting prior close, exiting end of day if gap did not fill. This not a recommended strategy.

Gap Fade Win % By Zone 69% 76% 75% 63% Prior Day Historical Win Rate “Win %” is based upon hypothetically fading opening gaps > 1 point in the E-Mini S&P 500 futures, 1998-2007, using no stop, targeting prior close, exiting end of day if gap did not fill. This not a recommended strategy.

Direction of Prior Day Should Be Considered Too Open Close Close Open Prior day “direction” incorporates the short term trend.

The Math…

Gap Fade Win % By Gap Zone Win % Prior Day 59% 66% 75% 78% 65% Prior Day Win % 71% 82% 75% 72% 54% “Win %” is based upon hypothetically fading opening gaps > 1 point in the E-Mini S&P 500 futures, 1998-2007, using no stop, targeting prior close, exiting end of day if gap did not fill. This not a recommended strategy.

Let’s Compare Similar Gaps in Four of the Zones… Zone A Zone B Nice concept but do they really work? Zone C Zone D

Test Scenarios 3-7 point gaps Four zones: 2 long & 2 short strategies Test 3 targets: exit end of day, gap fill, & 3 points beyond Test “no stop” & 6 point stop Compare win rate Compare profit factor (pf)

Scenario #1: No target, no stop, exit EOD 48% win .73 pf A B 53% win 1.27 pf Best “fade” candidate Best “go with” candidate Nice concept but do they really work? 42% win .51 pf 52% win .98 pf C D Baseline: 48% win rate, 1.0 pf (all zones)

Scenario #2: Target gap fill, no stop 65% win .87 pf A B 76% win 1.11 pf Historically profitable even with no stop Nice concept but do they really work? 68% win .84 pf C D 55% win .75 pf Baseline: 71% win rate, 1.05 pf (all zones)

Scenario #3: Target gap fill, 6 pt stop 59% win 1.22 pf A B 68% win 1.33 pf Using a stop made this a viable fade candidate Getting very interesting… Nice concept but do they really work? 55% win .85 pf C D 48% .85 pf Baseline: 61% win rate, 1.14 pf (all zones)

Scenario #4: Target 3 pts past gap fill, 6 pt stop 49% win 1.15 pf A B 58% win 1.52 pf Now we’re talking! Nice concept but do they really work? YUCK 36% .67 pf BLUD! (below low of up day) C D 41% .71 pf Baseline: 48% win rate, 1.09 pf (all zones)

Most zones have a bias to fill, but some do not. What Is Obvious? Scenario #1 No target, no stop, exit EOD Scenario #2 Target gap fill, no stop Scenario #3 Target gap fill, 6 pt stop Scenario #4 Target 3 pts beyond gap fill, 6 pt stop All Zones 48% win 1.0 pf 71% 1.05 pf 61% 1.14 pf 48% 1.09 pf Zone A .73 pf 65% .87 pf 59% 1.22 pf 49% 1.15 pf Zone B 53% win 1.27 pf 76% 1.11 pf 68% 1.33 pf 58% 1.52 pf Zone C 42% win .51 pf .84 pf 55% .85 pf 36% .67 pf Zone D 52% win .98 pf .75 pf 41% .71 pf Most zones have a bias to fill, but some do not.

“BLUD” zone: Below Low of Up Day Tip: Don’t Fade da’ BLUDs! Scenario #1 No target, no stop, exit EOD Scenario #2 Target gap fill, no stop Scenario #3 Target gap fill, 6 pt stop Scenario #4 Target 3 pts beyond gap fill, 6 pt stop All Zones 48% win 1.0 pf 71% 1.05 pf 61% 1.14 pf 48% 1.09 pf Zone A .73 pf 65% .87 pf 59% 1.22 pf 49% 1.15 pf Zone B 53% win 1.27 pf 76% 1.11 pf 68% 1.33 pf 58% 1.52 pf Zone C 42% win .51 pf .84 pf 55% .85 pf 36% .67 pf Zone D 52% win .98 pf .75 pf 41% .71 pf “BLUD” zone: Below Low of Up Day

Two weeks in the life of a “gapper”…

How I Trade Gaps Direction: mostly "fades" – though I do have a couple "go with" signals Pre-market Filters: primarily on where the gap opens (i.e. gap zone) Gap Size: totally dependent upon the zone Decision Time: based upon where prices are trading at 9:25 am ET Position Size: one contract for every $10,000 of equity Risk Management: if I’ve identified one or more risk factors, then I reduce my position size Stops: based upon points or a percentage of the gap amount, optimized by zone. I use a time-stop for some zones Targets: before, at gap fill, or beyond gap fill, depending upon the zone Entry Technique: at open (9:30 ET) using a market OCO (“One Cancels Other”) bracket order Exit Technique: at my target or stop, or end of day if neither hit. I never hold overnight. I manage some positions intraday. This ensures that I never suffer a full size loser that exceeds my max allowable money management loss on a single trade, while keeping draw-downs in a range that is psychologically tolerable.

Monday, April 7, 2008 Gap: up 9.5 pts Zone: below high & above open of prior “down” day Action: half size short at open Result: -6 pts ($300) per contract Time in trade: 3 hr, 25 min

Tuesday, April 8, 2008 Gap: down 7.25 pts Zone: below low of prior “down” day Action: no trade Result: missed a winner

Wednesday, April 9, 2008 Gap: down 2.25 pts Zone: below close & above open of prior “up” day Action: short half size (“go with” trade) at open Result: +3 pts ($150) per contract; scaled out +2.25, +3, +5 Time in trade: 28 min

Thursday, April 10, 2008 Gap: down 3.5 pts Zone: below close & above low of prior “down” day Action: long at open Result: +6.45 pts ($322) per contract, scaled out: +6 and +8.25 pts Time in trade: 1 hr, 46 min

Friday, April 11, 2008 Gap: down 16 pts Zone: “BLUD” - below low of prior “up” day Action: no trade Result: good call

Monday, April 14, 2008 Gap: down 1.75 pts Zone: below close of prior “down” day Action: half size long at open Result: closed at end of day for -2 pts ($100) per contract

Tuesday, April 15, 2008 Gap: up 7 points Zone: above high of prior “down” day Action: short at open Result: +4.3 pts ($215) per contract; scaled out +4, +6, and +5 pts Time in trade: 1 hr, 29 min

Wednesday, April 16, 2008 Gap: up 11.25 pts Zone: above high of prior “down” day Action: half size short at open Result: stopped for a full loss (-6 pts) ($300) per contract Time in trade: 1hr, 25 min 16th of month! Options expiration week

Thursday, April 17, 2008 Gap: down 8.75 pts Zone: below close, above open of prior “up” day Action: half size, discretionary (no signal) long at open Result: +5.33 pts (+$266.5) per contract (scaled out: +6, +3, and +8) Time in trade: 6 hr, 6 min.

Friday, April 18, 2008 Gap: up 19.75 pts Zone: above high of prior “up” day Action: no trade Result: good call

Summary The “gap fade” is a simple trade & a great foundation for a trading plan Know the zone! It pays to be picky Don’t leave money on the table - know which ones to close before or beyond gap fill